Developments in Cyprus during the past few days have raised many serious concerns about eurozone and wider EU banking regulations. The proposal for a ‘special tax’, a kind of ‘levy’, on bank deposits (savings) as part of a badly needed rescue package is especially worrying. In particular, the proposal to levy 6.75 per cent ‘tax’ on all deposits under €100,000 raises the specture of a widespread crisis of confidence, or ‘contagion’, in EU banking (since other EU countries that subsequently receive rescue funding could also be subjected to such a levy) and the specture of bank runs.
Greece, Ireland, Portugal and Spain have received rescue packages during recent months and the latest Cyprus bailout is still comparatively small compared with these previous rescues. However, Cyprus is a more complex rescue for several reasons. One factor here is the apparent large Russian influence and suspicion (especially in northern European creditor countries) that Cyprus is a conduit for illicit Russian money (which is denied by Cyprus).
The basic problem is that Cyprus has a broken banking system. Fuelled by Russian deposits, the Cypriot banking system is around 8 times bigger than the corresponding Cyprus GDP. It is also a highly concentrated system – the three largest commercial banks are five times bigger than GDP. The banks have experienced big losses on their holdings of Greek government debt and in their own financial dealings within Greece. It is reckoned that banks in Cyprus need up to €10bn in order to recapitalise.
The proposed rescue package in total is €17bn. This is a massive burden (it is around 95 per cent of Cypriot GDP) on a small economy. In order to mitigate its impact, a levy has been proposed on bank deposits - 6.75 per cent on deposits under €100,000 and 9.9 per cent on deposits over €100,000. Cyprus is currently in a state of extreme financial emergency.
The proposed levy on bank deposits has attracted a great deal of criticism and concern. This levy was apparently demanded by a Germany-led group of creditor countries. A primary objective is to reduce the cost of the bailout from €17bn.
There is an argument that deposits over €100,000 (so-called ‘wholesale depositos’) might be potentially subject to such a levy. They are typically above the ceiling for deposit protection (or deposit insurance) schemes and these deposits are held by more sophisticated (and wealthier) customers. The economic argument runs that these kinds of depositors (and those who invest in bank capital debt or bonds) have the skills and should be required to help discipline banking behaviour. They receive higher rates of bank interest and, therefore, they should be part of the overall ‘market disciplining’ of banks.
But even with this kind of depositor (and capital bondholder), there is a countervailing economic argument. This is that only bank regulators have the kind of detailed and often complex banking information needed to detect and discipline banking behaviour. Even bank regulators are often hard pushed to detect, quantify and police banking behaviour.
A related economic argument is that if these kinds of bank depositors and bondholders lose confidence in regulators and the banks, they will seek to take their funds out of the banking system. If this kind of behaviour spreads, it becomes a ‘contagion’ that can quickly mutate into a bank run when all bank depositors and creditors withdraw their funds. In modern globalised and highly integrated financial markets, these kinds of bank runs can spread quickly across national frontiers.
On balance, though, there is a stronger case that wholesale depositors and capital bondholders should be part of the overall market discipline process. Retail depositors, on the other hand, cannot be expected to have the skills and knowledge to assess bank soundness.
For bank deposits covered by the deposit protection (or deposit insurance) scheme, deposits under €100,000 (so-called ‘retail deposits’), the present proposals have no support from historical experiences. Indeed, banking history supports the economic dangers of this kind of proposed deposit levy on Cyprus. It is quite simply, an economic bungle. Unless shelved, it raises the specture of bank runs and a wider contagion beyond Cyprus to other EU countries who may need a similar kind of rescue package. So how does banking history support this view that retail deposits at least should never be subject to this kind of levy?
The most dramatic and formative experiences of what can happen and go wrong (and produce unintended consequences) is that of US experiences in the ‘Great Crash’ of the late 1920s and 1930s. This was a period of ‘laissez faire’ economics – the prevailing economic philosophy was that if banks had got themselves over-exposed in their lending and investing, then it was not the role of the State and taxpayers to bail them out. The result of this kind of thinking was the famous ‘bank holiday’ of 1933 when the US banking system effectively collapsed and was closed down for a week.
These US experiences were a fundamental reminder that banks (whether we like it or not) are ‘different’. From these experiences came important bank stabilising moves like the famous Glass-Steagall Act (which separated investment banking from retail banking); the principles of modern central banking (the central bank has to act as ‘lender of last resort’ when the banking system comes under liquidity pressure); risk-based capital adequacy rules; and deposit insurance.
These moves recognised that all banking systems are underpinned fundamentally by depositor confidence. In carrying out their important economic role of borrowing short and lending longer, banks are always exposed to liquidity risk. This latter risk is mitigated to the extent that it is underpinned fundamentally by the confidence that depositors have that they can always draw down their deposits when needed. So long as this belief exists, depositors do not have an incentive to run on their banks. Under these conditions, contagion risk (the risk of a bank run spreading to otherwise healthy banks) is minimised and the probability of a systemic risk (a generalised bank run) is much reduced.
To some extent, the maintenance of this confidence is a kind of ‘illusion’. It is an illusion to the extent that even the healthiest banks could not meet a serious run by their depositors without central bank liquidity help (as ‘the ‘lender of last resort’)
Within this apparatus of confidence maintenance, deposit insurance plays a fundamental role that is borne out by banking history, especially US experiences. Insuring retail deposits up to a set figure (like €100,000) acts as a disincentive for a depositor to run on a bank. In this sense, deposit insurance is itself a kind of unique kind of insurance – effectively, deposit insurance exists to help prevent the event insured against.
The new, proposed levy on Cyprus bank deposits, especially for those up to €100,000 (the retail deposits) ignores the lessons of banking history. The levy breeches deposit insurance protection and opens up wider questions on the kind of protection that retail depositors can expect. Leaving aside the legal and moral questions raised by such a levy, it is bad economics.
Political and punitive aims have dominated good economic sense. Even if such a levy could be economically justified, it would need to be related to the risk exposure assumed by each bank. In short, the more risky a bank, the higher the levy should be. But even here the retail depositor (rather than bank shareholders, senior bank management, the national bank regulator and the eurozone bank regulatory authority) is still being punished for the sins of others.
Cyprus banking is broke and Cyprus needs to be rescued. But the proposed bank deposit levy on retail deposits is a mistake, a bungle. The potential wider impact of this move on confidence in the eurozone banking system and wider EU banking could be calamitous. Cyprus has rejected this scheme and now has to come up (and quickly) with a more acceptable proposal, which may involve a more direct Russian role.
Professor Ted Gardener